Initial Observations on Pending Tax Cut Deal

While not quite at the 11th hour, it appears that lawmakers are finalizing a deal to avoid a major tax hike on all Americans on January 1st. By most reports, the deal involves much more than simply extending the Bush-era tax law beyond 2010. Other measures include a reduction in workers’ payroll taxes, business tax cuts, and the further extension of unemployment benefits.

Here are some initial observations of the key provisions of the deal:

Two-year extension of current tax rates for all taxpayers: The plan extends current tax law for all individual taxpayers including: the lowest rate of 10 percent and the highest rate of 35 percent; marriage penalty relief; the $1,000 child credit; and the 15 percent tax rate for capital gains and dividends.

Plus:

•· Taxpayers now have some certainty about their taxes beyond December 31, 2010.

Minus:

•· Taxpayers now know that their taxes will once again become a political football in 2012. Stability is one of the guiding principles of sound tax policy, but lawmakers have traded some near-term certainty for further long-term unpredictability. Taxpayers will not know how to plan their affairs beyond 2012.

Bottom line:

Lawmakers have known since 2003 that they had to address the expiration of the Bush-era tax cuts and should never have allowed the situation to get to this point. While extending these tax laws for another two years will reduce some of the uncertainty that has stifled the economy, lawmakers have not made the tax code any less complicated nor any more conducive to long-term economic growth.

Lawmakers should use the next two years to engage in a serious debate over how to make the tax simpler, more pro-growth, and more stable for taxpayers in the future.

One-year reduction in the payroll tax rate: The plan reduces the payroll tax (FICA) rate paid by employees by 2 percentage points, from 6.2 to 4.2 for 2011. This will mean a savings of $800 for a taxpayer earning $40,000, about $33 per-pay period for workers paid twice a month.

Plus:

•· The upside to cutting the payroll tax is that it avoids the “helicopter” approach to tax cuts of the Bush rebate checks in 2008 and the refundable nature of Obama’s Making Work Pay credit.

Minuses:

•· While the payroll tax cut is being sold as a way to stimulate the economy, it is becoming increasingly evident that temporary tax cuts have little, if any, stimulative effect. The rebates and temporary tax cuts of 2008 and 2009 are good examples as Hoover’s Michael Boskin wrote recently in the Wall Street Journal.[1] Citing the work of Franco Modigliani, Milton Friedman, and Robert Barro, Boskin points out that people make economic decisions such as major purchases based on their long-term finances, not a temporary windfall. These windfalls tend to be saved, not spent to stimulate the economy.

•· Because the payroll tax cut is temporary, lawmakers will have to revisit the issue again in 11 months to avoid another “tax hike” on working families. This raises the likelihood that this temporary payroll tax cut will become like so many other tax measures such as the Research and Development Tax Credit, the AMT “patch,” and the sales tax deduction that get lumped into the extenders bill that lawmakers rush to pass each December.

Bottom line:

Lawmakers should stop trying to “jump-start” the economy with temporary tax measures and instead turn their attention to making permanent tax changes that will increase economic growth for the long-term. As Boskin suggests, “If anything, we should lower marginal effective corporate and personal tax rates further (for example, along the lines suggested by the bipartisan deficit commission’s Erskine Bowles and Alan Simpson).”

Allow businesses to expense 100% of their investments in plant and equipment for one year: Typically, businesses expenditures are tax deductible in the year in which they are made, except for major purchases (such as large equipment or buildings) which must be written off over many years. This proposal would allow businesses to write off the entire cost of these major purchases in 2011 rather than depreciate those expenses over many years.

Plus:

•· At the margin, it is likely that this proposal will encourage some firms to purchase new plant and equipment in 2011 that they might not have done otherwise or which they may have put off for future years.

Minuses:

•· A study by economists Christopher L. House and Matthew D. Shapiro found that the temporary bonus depreciation enacted in 2002 and expanded in 2003 had a limited impact on the economy and jobs. They determined that: “While the policy noticeably increased investment in types of capital that benefited substantially from bonus depreciation, the aggregate effects of the policy were modest. The analysis suggests that the policy may have increased output by roughly 0.1 percent to 0.2 percent and increased employment by roughly 100,000 to 200,000 jobs.”[2]

•· Bonus depreciation is only beneficial for profitable businesses or those with positive taxable income. As was the case with the previous bonus depreciation plans, firms that were in a net operating loss position or those that had no taxable income, were unable to take advantage of the tax benefit from purchasing new equipment. This limits its stimulative effect.

•· To the extent that the plan does encourage firms to accelerate future investments into 2011, what impact will that have on the economy in 2012 and beyond? Will this be the business investment version of “cash for clunkers” program – which had little net impact on auto sales – because people simply moved up purchases they would have made anyway.

Bottom line:

In general, economists favor full expensing over depreciation, especially since depreciation rules are often arbitrary and have little relationship with the economic life of the investment. However, full expensing loses its economic effectiveness if it is temporary in nature.

While there is considerable merit in moving toward full expensing as a rule, a more immediate need for the economy and U.S. competitiveness is cutting the corporate income tax rate, which remains one of the highest in the industrialized word. A 2008 study by economists at the OECD determined that the corporate income tax is the most harmful tax for long-term economic growth.[3] So as lawmakers look for policies that will produce the best long-term benefits for the economy, cutting the corporate rate should be a top priority.

[1] Michael Boskin, “Why the Spending Stimulus Failed,” Wall Street Journal, December 1, 2010. http://online.wsj.com/article/SB10001424052748704679204575646994256446822.html?KEYWORDS=boskin

[2] Christopher L. House & Matthew D. Shapiro, 2008. “Temporary Investment Tax Incentives: Theory with Evidence from Bonus Depreciation,” American Economic Review, American Economic Association, vol. 98(3), pages 737-68, June. http://www.nber.org/papers/w12514

[3] Asa Johansson, Christopher Heady, Jens Arnold, Bert Brys and Laura Vartia, “Tax and Economic Growth”, Economics Department Working Paper No. 620. ECO/WKP(2008)28, Organization for Economic Cooperation and Development, July 11, 2008.http://www.olis.oecd.org/olis/2008doc.nsf/LinkTo/NT00003502/$FILE/JT03248896.PDF